Most debts can be divided into good or bad debt, depending on whether it is tax deductible or not. You might decide to start with your bad debts before tackling the good debts, however you will eventually want to pay off all your debts, good as well as bad. True wealth comes from your net worth and the assets you own that bring you an income. Financial independence comes from making enough money from your assets to exceed your expenses. Remember, DEBT IS NOT WEALTH. Debt is debt and will eventually have to be repaid.
Firstly, work out what extra money you can put aside to add to your debt repayments. Any extra amount you can add to your repayments will help reduce the debts so much quicker.
Next, compile a list of all your debts. Include your mortgage, car loans, credit cards, store cards, loans from friends and family, school fees, anything that you owe basically.
Write them on a piece of paper down the page or put them into a spread sheet.
- Write down what it is, eg. home loan, credit card, car loan store card etc.;
- List the remaining balance owed (what is left to repay, not the initial loan amount, so unless you haven’t made any payments yet, this should be less than the value of the total loan);
- Then put the minimum monthly payment;
- You can also put in the interest rate for your information.
You should have four columns. You will need a fifth column. This is for your debt ratio calculations on each loan to work out your order of repayment.
Taking the first debt, divide your monthly payment into your debt balance. This should give you a number. So for example, if you have a $2,000 loan, and your monthly repayments are $100, the debt ratio is 20.
$2000 ÷ $100 = 20
Now do this for all your loans to give you your debt ratio number for each loan.
Rewrite your list or rearrange your spread sheet in order of the loan with the lowest debt ratio to the highest debt ratio.
This is the order in which the debts will be repaid. What’s important to note here is that the earlier debts to pay off are not necessarily the debts with the highest interest rates. The ratio lists the debts in the order that have the most impact on your cash flow.
Add the extra money calculated earlier to the first debt payments on the list, while still making the minimum monthly repayments on all the other debts. Keep paying off the number one debt on your list, with the extra payment until this one is paid off.
Now, if this was a credit card or store card debt, this does NOT mean that this is now available for spending again. Remember the goal here is to eliminate all your debts, not incur new ones.
In addition, this money is not available for you to spend yet. We’re on the path to financial independence remember, so we will have some short term pain for long term gain.
The entire amount that was used to pay down the first item is now available to be put into the second debt on your debt ratio list AS WELL AS the minimum monthly payment for this debt.
When the second item on the list has been repaid, the entire amount is now used to pay off the third item on the list.
So now the repayment amount is the minimum monthly payment for this debt PLUS the minimum monthly payment for the previous debts PLUS the extra amount you were able to put aside in a bid to actively reduce your debt.
You will find that because you are making extra payments, your repayment time is drastically reduced. You might even find that a debt further down the list which you haven’t gotten to yet, actually gets paid out before you have a chance to get to it, as you are still making the minimum monthly repayments into this debt. If this happens, add this minimum payment to your other debts.
Because you were already making minimum monthly payments to the other loans with just a bit extra into the current loan, you’ll find you don’t even miss the amounts you are directing into the next debt on your ratio list, as you were already making this payment anyway. Now it’s being put to a good purpose in reducing the amount of “dead money” interest you are paying.
Keep doing this until all your debts are repaid. Now, and this is very important, DON’T GET INTO FURTHER DEBT. Keep one of you credit cards if you must, and pay it off IN FULL at the end of each cycle.
Since you didn’t miss the money when it was being used for debt reduction, you can now redirect this “spare” money into your savings and investments.